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Ch 09 The Cost of Capital
1. "Capital" is sometimes defined as funds supplied to a firm by investors.
a.
True
b.
False
2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a
firm uses to acquire assets.
a.
True
b.
False
Ch 09 The Cost of Capital
3. The component costs of capital are market-determined variables in the sense that they are based on investors' required
returns.
a.
True
b.
False
4. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for
use in capital budgeting?
a.
Accounts payable.
b.
Common stock “raised” by reinvesting earnings.
c.
Common stock raised by new issues.
d.
Preferred stock.
e.
Long-term debt.
Ch 09 The Cost of Capital
5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of
developing the firm's WACC.
a.
True
b.
False
6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding
debt.
a.
True
b.
False
Ch 09 The Cost of Capital
7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
a.
True
b.
False
8. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate
its WACC.
a.
True
b.
False
Ch 09 The Cost of Capital
9. Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These
bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the
firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
a.
4.35%
b.
4.58%
c.
4.83%
d.
5.08%
e.
5.33%
Ch 09 The Cost of Capital
10. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity
and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is
40%. What is the component cost of debt for use in the WACC calculation?
a.
4.28%
b.
4.46%
c.
4.65%
d.
4.83%
e.
5.03%
Ch 09 The Cost of Capital
11. Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon,
paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax
rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate
was adopted?
a.
0.57%
b.
0.63%
c.
0.70%
d.
0.77%
e.
0.85%
Ch 09 The Cost of Capital
Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted
average cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets
$ 38,000,000
Net plant, property, and equipment
101,000,000
Total assets
$139,000,000
Liabilities and Equity
Accounts payable
$ 10,000,000
Accruals
9,000,000
Current liabilities
$ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value)
40,000,000
Total liabilities
$ 59,000,000
Common stock (10,000,000 shares)
30,000,000
Retained earnings
50,000,000
Total shareholders' equity
80,000,000
Total liabilities and shareholders' equity
$139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with
semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the
yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an
average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
12. Refer to the data for the Collins Group. What is the best estimate of the after-tax cost of debt?
a.
4.64%
b.
4.88%
c.
5.14%
d.
5.40%
e.
5.67%
Ch 09 The Cost of Capital
13. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a
corporation may be excluded from the receiving corporation's taxable income.
a.
True
b.
False
Ch 09 The Cost of Capital
14. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the
preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible
by the issuing firm.
a.
True
b.
False
15. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost
of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,
theoretically, be
Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50).
a.
True
b.
False
Ch 09 The Cost of Capital
16. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the
company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is
the company's cost of preferred stock for use in calculating the WACC?
a.
8.72%
b.
9.08%
c.
9.44%
d.
9.82%
e.
10.22%
Ch 09 The Cost of Capital
17. A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the
company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's
cost of preferred stock?
a.
7.81%
b.
8.22%
c.
8.65%
d.
9.10%
e.
9.56%
18. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on
the firm's common stock.
a.
True
b.
False
Ch 09 The Cost of Capital
19. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first
source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm.
a.
True
b.
False
20. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments
associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds
does have a cost.
a.
True
b.
False
Ch 09 The Cost of Capital
21. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity
raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other
factors.
a.
True
b.
False
22. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's
outstanding common stock.
a.
True
Ch 09 The Cost of Capital
b.
False
23. The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs
on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the
earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on
the opportunity cost principle.
a.
True
b.
False
Ch 09 The Cost of Capital
24. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or
short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and
(3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.
a.
True
b.
False
25. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued
stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only
the dividend growth method is widely used in practice.
a.
True
b.
False
Ch 09 The Cost of Capital
26. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater
impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.
Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on
long-term debt.
a.
True
b.
False
27. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the
required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held
constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would
not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit
the shift toward debt.
a.
True
b.
False
Ch 09 The Cost of Capital
28. When working with the CAPM, which of the following factors can be determined with the most precision?
a.
The beta coefficient, bi, of a relatively safe stock.
b.
The most appropriate risk-free rate, rRF.
c.
The expected rate of return on the market, rM.
d.
The beta coefficient of "the market," which is the same as the beta of an average stock.
e.
The market risk premium (RPM).
Ch 09 The Cost of Capital
29. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from
reinvested earnings based on the CAPM?
a.
11.30%
b.
11.64%
c.
11.99%
d.
12.35%
e.
12.72%
30. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You
have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach,
what is the cost of common from reinvested earnings?
a.
9.67%
b.
9.97%
c.
10.28%
d.
10.60%
e.
10.93%
Ch 09 The Cost of Capital
Collins Group
The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted
average cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets
$ 38,000,000
Net plant, property, and equipment
101,000,000
Total assets
$139,000,000
Liabilities and Equity
Accounts payable
$ 10,000,000
Accruals
9,000,000
Current liabilities
$ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value)
40,000,000
Total liabilities
$ 59,000,000
Common stock (10,000,000 shares)
30,000,000
Retained earnings
50,000,000
Total shareholders' equity
80,000,000
Total liabilities and shareholders' equity
$139,000,000
The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with
semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the
yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an
average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
31. Refer to the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?
